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Estonia to Join the Euro Despite Financial Crisis

June 18, 2010

On Thursday, the European Union announced that Estonia would become the 17th member of the Euro Zone, officially replacing its kroon with the euro on January 1, 2011.  The New York Times ran an article on Friday that acted surprised a country would want to join the Eurozone while the currency suffers its worse crisis to date. However, the article failed to mention that due to the structure of the kroon, Estonia already basically uses the euro without reaping all the benefits of getting to sit on the European Central Bank’s council that sets interest rates and Estonians currently have to pay the cost of exchanging money when interacting with Eurozone.

Estonia established a currency board in 1992 when it created the kroon, pegging the exchange rate at 8 kroon equaling on Deutsche Mark (DM).  A currency board is a sort of “super peg,” because not only does the exchange rate not fluctuate, but every kroon is backed by its equivalent in Deutsche Mark (and later euros when Germany joined the Eurozone) which are held by the central bank.  Thus, it is very hard for financial markets to attack the peg, as the central bank guarantees that the kroon can be converted into DM on demand and will always hold enough DM to cover all transactions.

As a result, the kroon’s exchange rate fluctuates with other currencies at the same rate as the euro.  Thus, the kroon has already been depreciating along with the euro against the dollar, yet Estonia has less control over the euro than say Greece, since Greece is a full euro member and has representation on the European Central Bank.  Secondly, since the kroon is so tied to the euro, the Estonian Central Bank has little control over interest rates as it cannot increase the money supply of kroon without first acquiring more euros.

Therefore, it makes sense for Estonia to join the Eurozone as quickly as possible, but first it had to meet the criteria of the Economic and Monetary Union (EMU).  There were five requirements that a country must meet before joining the euro:

  1. A budget deficit of less than 3% of GDP
  2. A national debt less than 60% of GDP
  3. Exchange rates with the euro cannot fluctuate by more than 15% in the two years before accession into the Eurozone
  4. Long term interest rates must vary by less than 2% in comparison to the three lowest rates in the Eurozone
  5. Inflation may not exceed the average of the three lowest rates in the Eurozone by more than 1.5%

Most of these criteria were easy for Estonia to satisfy.  Due to the currency board arrangement, the exchange rate requirement was not an issue.  Also, when Estonia became independent from the Soviet Union in 1991, it started fresh with no national debt, and even 19 years later, Estonia’s national debt is only 7.2% of GDP.  This low level of debt also symbolizes that Estonia keeps its deficits down.

However, as the chart above shows, Estonia had problems keeping its inflation low.  Part of the problem was the Estonian economy has boomed since 1991 (second graph), which has allowed Estonia’s standard of living to grown compared to the Eurozone (third graph).  The second problem was that Estonia started independence with high inflation (like every post-Communist country), and the currency board made it impossible for Estonia to just start printing money, the country also lost control over interest rates (a key tool in battling inflation).  Ironically, when the Estonian economy went into recession in 2008 and the government was forced to impose tough austerity measures, inflation then nose-dived in 2009, reaching 0.2%.  This was lower than the Eurozone’s 0.3%, allowing Estonia to adopt the euro.

From Estonia’s perspective it makes sense to join the euro, since it is already tied so strongly to the euro and it will now reap more benefits.  For the euro, while some may consider adding a 17th member foolhardy right now, it is hoped that the addition of a new member will demonstrate a renewed confidence in the euro.  However, other countries that might be able to meet the requirements to join the euro may wait for calmer days, as their monetary policies may not be so focused on the euro.

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